Cost analysis and cost models

Cost analysis and cost models

Cost analysis is a key skill of the procurement professional. If procurement is the acquisition of goods and/or services at the best possible total cost of ownership then the buyer needs to have 100% visibility into the supplier’s price. The total price quote of the supplier is made up basically of two parts : the cost of the commodity and the supplier’s desired profit margin.

Cost analysis allows the buyer to establish the “should cost” of a commodity. A model is constructed using all the data that can be assembled, including what can be extracted from the supplier.

Follow these 8 steps to make a cost model for your commodity or service:

  • First identify the cost elements. For a product, these are raw material costs, labor costs, inventory costs and overhead costs.
  • Identify the cost drivers. Each cost element has an underlying basis that determines the cost. As an example the cost drivers for labour costs would be employee and contractor wages (per hour/per day/per job) and labour productivity.
  • Keep it simple. Do not overcomplicate the analysis by including more than the critical cost elements. Simple cost models are easy to execute and monitor.
  • Make your cost model unique to each commodity. Every commodity has different key cost drivers.
  • Include all cost elements in the model. This includes, but is not limited to, raw material handling costs, transportation and storage, warranties, cost of holding inventory and waste. It also includes internal costs such as administration of orders and invoices.
  • Engage with the supplier. A cost analysis without including input from the supplier will not be complete or accurate. The supplier’s cost is not equivalent to the price paid. It is possible to establish the supplier’s overheads and profit margin by analysis and by discussion.
  • Use the best quality data available. Prices must be gathered from as many other suppliers and sources as possible. Understand utility and energy input costs, labour rates and factory overhead costs.
  • Make it easy to understand. A full cost analysis should be in a tabular or graphical format. It is important to be able to communicate all the cost elements to stakeholders and decision makers.

The analyst needs to understand the key cost elements and their cost drivers as well as the supplier’s overheads and profit margin. Making a cost model for given commodity is not “rocket science”, just apply common sense to as much accurate information as possible and assemble it in a meaningful and easily understandable format. Cost analysis can ensure that you know that you are paying a fair price.