PRICE DUE DILIGENCE THROUGH SHOULD COST ANALYSIS

In supply chain management, procurement professionals will strive to acquire goods and services as cheaply as possible while the supplier’s motive is to maximize the highest possible margins. These are two mutually exclusive objectives. Tighter product development windows and the increasing pressure on profit margins will force suppliers to come up with profit margins that are unreasonable. Procurement professionals on the other hand will be pushing for further cost savings. In an effort to optimise efforts towards shared outcomes, it may be important for both parties to compromise their positions and establish shared goals for collective value. It may be necessary for suppliers and buyers to realize that winning does not depend on someone losing. Someone’s success does not signify someone’s failure. What is clear and very clear is that the hands of time will certainly not favour the winner-take-all mentality with eternity. It is important for suppliers and procurement professionals to level-set so that they are at the same level of thinking.

Supply chain professionals have relied upon the should cost analysis model to conduct a forensic form of cost validation that take into account all factors of production. The model entails looking very closely at all the little pieces that make up the cost of goods. Should cost modelling can be defined in a single sentence as a fairly scientific cost estimator. The requirement for comprehensive cost analysis has become more pronounced than ever before. The model will take into consideration various costs such as the cost of raw materials, direct labour, indirect spend, business overheads, production costs, transportation and shipping costs, sales and marketing costs, back up support services and reasonable mark-ups in order to come up with the total cost of the product. Supply chain professionals are also required to take into account various additional factors such as inflation, exchange rates, government taxes, contingencies and potential supply chain uncertainties to better understand the make-up of costs for their product categories.

The disparity between quoted prices by suppliers and outturn costs is widely acknowledged within supply chain circles. As procurement professionals conduct their price due diligence assignments, the overarching objective of should cost analysis is therefore to close the gap between what a product ‘should cost’ and what it ‘does cost’ thereby establishing a practical foolproof approach to cost validation analysis. The model will help in building a holistic picture of the economics behind the manufacturing process of the product. The process will bring wider strategic insights into cost structures which is far beyond the traditional remit of cost breakdown analysis. The price due diligence exercise will give supply chain personnel the opportunity to measure what it takes to build a finished product giving a clear roadmap to identify potential cost savings.

Should cost analysis delves beyond the upfront procurement cost by uncovering concealed supply chain expenses across the entire product lifecycle, taking the guesswork out of procurement decisions while at the same time providing answers to the most difficult questions. As price due diligence results have demonstrated, supplier pricing structures can easily stray from the normal curve but should cost analysis will always provide a platform to question exaggerated markups by suppliers, thereby providing pricing structures that are rooted in practical cost breakdowns. The model will also assist suppliers in identifying areas where they will be able to streamline their processes, reducing waste while utilizing raw materials efficiently.

Should cost modelling is also predominantly used by design engineers to produce and test multiple product design alternatives with a view to speed up production to market cycles. Production engineers will often target to implement the desired circuits for lower cost production. The model will be utilized for reengineering product categories through design improvements, use of material substitutions or cost-effective components and or process optimizations, often targeting overly complex parts in need of simplification and re-engineering. Often times the unnecessary unique features of a component’s design might create expensive production challenges. During the product development phase, engineers usually over design for functionality without necessarily taking into careful consideration cost implications.

With the advent of price due diligence, should cost analysis models will give design engineers the opportunity to take a closer look at their blueprints with a view to address cost outliers. The model will provide a handy goalpost for coming up with re-engineering optimum designs which will assist in the identification of apt raw material components in the early stages of product designs, avoiding design iterations in the later stages of the product development cycle. Should cost analysis can inform whether to opt for a make or buy decision, whether to seek alternative raw materials or whether to seek alternative suppliers. As part of price due diligence, should cost analysis can be reliable upon to highlight cost drivers and potential inefficiencies in the manufacturing processes. The model will assist suppliers to re-consider and create avenues for continuous improvement to achieve better cost efficiency.

It is often said that in business, you don’t always get what you deserve, but you get what you negotiate for. Recognizing that an asking price is not always a taking price, supply chain professionals will be in a position to utilize the information that is gathered through should cost analysis to challenge the pricing structures of a supplier where the estimated cost is deemed to be above open market price. When conducting price due diligence exercises, should cost analysis is considered as a baseline reference point for use in conducting price negotiations after identifying mis-priced components and those components with high markups. Should cost modelling is positioned at the intersection of product development, engineering production and procurement, allowing the potential to foster collaborative approach to cost avoidance, cost minimization and reduction.

Supply chain professionals are required to be more knowledgeable about the supplier’s business than the supplier itself. There is need to periodically poke holes into the supplier’s cost estimation processes as part of the negotiation process. The results of a should cost analysis model will serve as a good foundation for discussion, giving supply chain professionals negotiating power to challenge higher-than-average profit margins demanded by suppliers. The detailed knowledge and understanding of what the product should actually cost will transfer the power of negotiation from the supplier to procurement professionals. It will shift the burden of responsibility to the supplier to justify its exorbitant pricing structures, whenever so required.

Should cost modelling should also be utilized for risk management in supply chain. The model of analysis can assist the business to identify risks associated with raw material scarcity, potential supplier disruptions and or fluctuating market dynamics. The model will assist in understanding supplier strengths with a view to understand whether they can meet current and future requirements at scale.

It must also be noted that for purposes of price due diligence, should cost models hinges on data-driven and factual analysis. The predictive power of the model is ordinarily heavily reliant on the use of historical data, industry benchmarks and current market trends to identify cost drivers. By using this model, there will be diminishing dependence on instinct or intuition in making business decisions on cost related variables. It has been readily accepted in procurement cycles that should cost modelling is a robust cost analysis framework that will always rely on both internal and external data sources to identify cost outliers.

The model seeks to examine supply chain costs at a granular level and then adds up all costs to establish the accurate reflection of the actual cost of producing a product. Such facts can be relied upon to grasp the authentic cost determinants providing a clear understanding of how to reduce supplier mark-ups to the barest minimum possible. The reliance on historical and real-time data guarantees a robust foundation for the creation of accurate and reliable cost projections. It will assist in unpacking the complex nature of supplier computations with enhanced confidence and increased accuracy. It is a scientific journey to price discovery which will promote well-founded supply chain decisions supported by unparalleled insights into the true cost of products and services.

Supply chain challenges are seemingly ballooning in complexity and scale. And in the face of slowing industry growth and intense competition, supply chain professionals are hard wired to create cost savings for their supply chains. Should cost analysis is a great opportunity identified and acted upon by those supply chain professionals who are intent on pushing the cost saving envelope forward. Supply chain experts believe that should cost analysis is a decisive metric in the validation of costs through price due diligence exercises. Should cost analysis has often been hailed as instrumental in getting most firms out of the red side and firmly on to the black side of the corporate ledgers.

Should cost analysis is a pro-active price due diligence model. It compares favorably to those other cost analysis models that are nothing more than postmortem certificates. An organization that will master the art of should cost analysis becomes the poster child for today’s concept of value validation through price due diligence. Should cost analysis seems to be extending beyond the immediate sought after benefits of value creation. We are entering a new frontier where cost analysis is a core element in important corporate conversations. Your degree of success much depends in no small measure on how well you execute the basics.

In conclusion, it must always be remembered that whenever someone raises a cup of coffee to his mouth, there is always a complex supply chain process flow behind every sip. Should cost analysis should be treated as an ongoing and iterative process producing pricing models rooted in practical cost breakdowns. The use of the should cost models is expected to gather steam in the years ahead. It is a tangible reality shaping the future of supply chain management. It will offer more certainty in what may seem to be the neglected world of cost modelling. Supply chain professionals will need to avoid being captive to the supplier’s unreasonable pricing structures. Whenever this happens, the top line and the bottom line will take a hit. Both lines will go south. Amid the domino effect of rising prices from suppliers, supply chain professionals should possess enough visibility into their cost drivers through regular price due diligence exercises.

Charles Lovemore Nyika is a Supply Chain Practitioner based in Harare, Zimbabwe. For views and comments, he can be contacted at [email protected]