What Is a Should Cost Analysis and When Is It Used?

Should cost analysis is a methodology used to determine the theoretical optimal cost of a product, service, or process. It involves breaking down the cost structure into its fundamental elements to understand what an item should cost if produced efficiently. This approach provides a benchmark for evaluating actual or quoted prices. It moves beyond simply accepting a supplier’s price by delving into the underlying cost drivers. By performing this analysis, businesses can gain insights into fair pricing and identify opportunities for cost optimization.

Defining Should Cost Analysis

Should cost analysis, also known as should costing or cost breakdown analysis, is a structured framework for estimating the true cost of a product or service. Its main objective is to provide transparency into cost drivers, helping organizations understand what a good or service should cost if produced under efficient manufacturing and distribution practices. This differs significantly from “will costs,” which represent actual invoice cost data or current market prices. It is a proactive, analytical approach that dissects expenses into categories such as materials, labor, and overhead. This analysis provides a benchmark for price negotiations and a foundation for strategic sourcing decisions. By comparing the estimated “should cost” to actual supplier quotes, companies can identify discrepancies and potential inefficiencies.

Elements of Cost Breakdown

To arrive at a “should cost,” the analysis breaks down all elements contributing to a product or service’s cost. Direct costs form the foundation, encompassing expenses directly tied to production. This includes raw materials, the fundamental components used, and their costs are based on factors like market prices and delivery. Direct labor costs account for the wages, salaries, and benefits of employees directly involved in the manufacturing process. Tooling costs, expenses for specialized equipment or molds, are also considered direct costs, often estimated based on tool supplier charge-out rates.

Indirect costs, often referred to as overhead, are expenses necessary to run the business but are not directly traceable to a specific product unit. These can include manufacturing overhead, such as utilities for the factory, equipment maintenance, and facility rent. Administrative costs, covering salaries for administrative staff, office supplies, and general operational expenses, also fall under indirect costs. Research and development (R&D) expenses, incurred during the creation of new products or processes, are another indirect cost component.

Finally, a reasonable profit margin for the supplier or manufacturer is included in the “should cost” calculation. This margin accounts for the supplier’s return on investment and business viability.

Approaches to Should Cost Analysis

Various methodologies are employed to conduct a should cost analysis, each offering a distinct perspective on cost estimation.

Bottom-up analysis builds the cost from the ground up, detailing every material, labor hour, and process step involved in production. This granular approach requires comprehensive data on components, manufacturing processes, and labor rates, allowing for a precise understanding of cost drivers.
Top-down analysis utilizes high-level data, historical costs, and industry benchmarks to estimate costs. This method is often quicker and suitable when detailed information is limited, relying on aggregated data to project expenses.
Parametric modeling employs statistical relationships between cost and technical parameters. This approach uses mathematical models to estimate costs based on product characteristics, such as size, weight, or performance attributes.
Tear-down analysis involves physically disassembling a product to understand its components, materials, and manufacturing processes. This hands-on approach provides direct insights into the product’s construction and can reveal opportunities for design or material optimization. It helps in reverse-engineering the cost structure by identifying the types and quantities of materials and labor needed.

When Should Cost Analysis is Applied

Should cost analysis is applied in several strategic business scenarios. A primary application is in supplier negotiations, where it helps determine fair pricing for goods and services. By understanding the true cost, businesses can negotiate more effectively, challenging inflated prices and fostering transparent discussions with suppliers.

During new product development, should cost analysis is used to set target costs. This ensures that products are designed within cost constraints from the outset, influencing material selection and manufacturing processes. It also aids in make-or-buy decisions, providing a clear cost comparison between producing an item internally versus purchasing it from an external supplier.

Should cost analysis helps identify areas of inefficiency and potential savings by pinpointing cost outliers and drivers. This systematic approach allows organizations to reduce expenses without compromising quality.